According to the National Association of Realtors, about 9% of recent home buyers borrowed money from their 401k plans (or pensions) to put a down payment on a new home. Borrowing from your 401k is not a bad options considering the low mortgage rates today (about 3.5% on a 30-year fixed rate). Be forewarned, there are several considerations you must know about.
When you borrow from your 401k, you pay the interest to yourself. Normally, that’s a point or two above prime, which is 3.25% right now. You may borrow up to half of your current 401k balance, up to a max of $50,000. You must repay the loan within five years typically, though some employers may give you up to 15 years if you are buying a home.
The loan will not count against your debt to income ratio when you apply for a mortgage. The reason being is that your loan is secured by the funds in your 401k. Further, they are not reported to credit bureaus so the loan won’t hurt your credit score.
If you do not repay the loan, it will be treated as a taxable distribution. You’ll owe taxes plus a 10% early withdrawal penalty if you are under age 59 1/2. Moreover, if you leave your job for any reason, you’ll have only 60-90 days to repay the entire loan. Again, the amount will be taxed and you’ll owe the early withdrawal penalty if you were under 55 when you left your job.
Although you’re paying yourself back, you’ll lose out on earnings you would have been receiving had you not borrowed from your plan. Plus, if you stop contributing (or lessen your contributions) while you repay the loan, you’ll put yourself into a bigger hole. Further, you’ll be repaying the loan with after-tax dollars. When you start taking distributions during retirement, you will be taxed again.
An alternative is to go with a lower down payment, but you’ll end up with a higher interest rate and have to pay for mortgage insurance. “Private mortgage insurance premiums range from 0.5% to 1.15% of your loan amount. PMI usually remains in effect until you have at least 20% equity in your home. Annual mortgage insurance premiums for FHA loans are higher — 1.35% for most loans — and remain in effect for the life of the loan,” adds Sandra Block at Kiplinger.com. For more info, check out this article.